Once bitten, twice shy? Central banks should heed the bubble warnings
LONDON (Reuters) – If central banks have learned anything from the Great Financial Crisis, the worst since the 1930s, it is that you don’t need runaway inflation to raise interest rates. Financial-market bubbles should be enough.
The Bank for International Settlements, often considered the central bank to the world’s central banks, warned on Sunday that policy makers should press ahead with the “great unwinding” of postcrisis stimulus, even if “some short-term bumps in the road” are inevitable.
Inflation shouldn’t be the “be all and end all” of monetary policy, according to BIS head of research Hyun Shin. Instead, “a bit more emphasis” should be put on financial developments, such as the rise in credit growth and the potential economic costs of bubbles bursting.
Shin and his colleagues should be listened to. The BIS was one of the few institutions warning that the credit bubble being inflated by the Alan Greenspan Fed’s super-lax policy in the mid-2000s would burst with disastrous consequences.
But even after the financial crisis plunged the world into recession and scarily close to another Great Depression, inflation is still the “be all and end all” for central banks across the developed world. Parallels between now and then are emerging.
Inflation in the industrialized world is now broadly where it was a decade ago: extremely well contained and below most central banks’ 2% target. Against a backdrop of anemic wage growth and oil slumping 20% in the last two months, there’s little sign of it accelerating any time soon.
In that light, the subtle but notable shift among major central banks recently toward policy “normalization” is unwarranted. But while inflation poses no threat, the same cannot be said with any surety about financial markets.
The warning signs are there: World stocks are the highest on record, volatility is the lowest in decades, and in credit, emerging-market and high-yield spreads are the narrowest in years. Despite the Fed raising rates, US financial conditions are the easiest in over two years, according to Goldman Sachs.
Credit growth and global debt are now higher than they were before the crisis. Bubbles are forming in equity and other markets, inflated by global central-bank stimulus, which is still running at nearly $200 billion a month.
Reflecting investors’ hunt for yield, Argentina last week issued a 100-year bond at a yield of less than 8%. Argentina has defaulted at least eight times since gaining independence in 1816 and has been in a state of default more than half of all days since 1980. Yet investors snapped it up.
As Citi’s Matt King notes, markets remain “in thrall to central banks.”
GRIN AND BEAR IT
This is why tighter policy globally could be potentially seismic for markets. Investors have grown fat and happy on more than two decades of policy makers targeting inflation at 2% and offering the implicit insurance policy of the central-bank “put.”
That’s the belief that central banks will do whatever it takes to avoid the financial and economic damage a crash would unleash. Essentially that means maintaining a loose monetary policy and the flow of liquidity into financial assets.
Last week, Bill Dudley, president of the New York Fed, and Andy Haldane, chief economist at the Bank of England, jolted markets by signaling their readiness to raise rates.
The Fed has already raised rates four times and is about to reduce its balance sheet, and the European Central Bank and Bank of Canada to varying degrees have made it clear that the postcrisis stimulus should soon be gradually withdrawn.
The arguments against using monetary policy to curb financial-market excesses are well known, powerful and held by most of the world’s central-banking elite over the past quarter century.
It’s too blunt a tool, the concept of financial stability is too vague, it’s impossible to accurately identify asset bubbles, and the economic and financial fallout from pricking these bubbles is unknowable at best and catastrophic at worst.
Ultimately it’s not the business of central banks to be micromanaging markets. It’s not their remit.
Central bankers including Greenspan, Ben Bernanke, Mervyn King, Lars Svensson and Jens Weidmann have argued that monetary authorities should resist leaning against the wind and trying to control or even prevent incipient financial booms.
But in recent years the Fed has acknowledged the risks posed by ultralow volatility and increased risk-taking. In 2014, Janet Yellen said high-yield, or “junk,” bonds were on the Fed’s radar, warning that a sharp unwind of risk-taking behavior in general would be something to avoid.
A major shakeout in US high-yield bonds followed, and yields jumped to 10% in early 2016. But they’re now back to historic lows of around 5.5%, the recovery coinciding almost exactly with the most gradual Fed tightening cycle in history.
This shows that higher rates are failing to quell animal spirits. On this issue, Shin at the BIS and perma-bear Albert Edwards at Societe Generale agree that the longer bubbles are left to inflate, the greater the disaster when they pop.
Edwards points out the irony in trying to reflate the economy through ultra-loose policy, because bursting bubbles will take down the economy and probably deliver the very deflation policy makers were seeking to avoid in the first place.
“Even after the [Great Financial Crisis], they simply have not learnt that loose-money polices to blow asset price bubbles is a catastrophic policy destined to end in failure,” Edwards warned.